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Wednesday, 22 August 2012

Islamic Finance Leads the Way

Ironically, the global financial crisis has triggered conservative investing through non-conventional means: non-Muslims are increasingly choosing to invest through Islamic institutions’ portfolios. The irony is particularly striking in the US, since Islamic financing often times carries the misnomer of “terrorist-financing”. However, for those looking to pursue more ethical investments, and with the rise of socially responsible investment culture, Islamic financial institutions create a new investing culture—specifically through Islamically-managed hedge-funds.

Before one identifies further trends that reflect the “mainstreaming” of Islamic investments, two questions frame the modern appeal of Islamic finance: 1) what are the religious prescriptions for this type of investment; and, 2) why would non-Muslims choose a mutual fund that follows Islamic Law while many non-Muslims worry that Islamic Law will trickle into their secular nations’ legislative process? The latter is a glaring paradox. According to Reuters Business Times Malaysia, the mixture of Islamic financial instruments (investments that adhere to religious principles) considers risk as well as appeals to those wishing for more transparency on the types of industries that comprise the investment portfolios. Furthermore, the upward trend of socially responsible investment (SRI) is due to the younger, progressive mentality of ‘social responsibility,’ as illustrated by a financial magazine’s listing of options that incorporated human rights and the environment factors into portfolios.

The United Arab Emirates established the first Islamic banking institution. Outside of the Gulf Cooperation Council, four Islamic banks operate in Lebanon, while Tunisia is considering expanding its financial industry. Today there are over 300 institutions spread across six continents. For the last decade, Muslim-majority, Middle East, and North African (MENA) countries have used or promoted Islamic finance for three reasons. First, Islamic finance prohibits any financial returns from usury, or excessive interest rates, known asRiba (usury). Instead, a financial return is derived on a participatory, profit and loss sharing (PLS) basis called mudaraba andmusharaka contracting. This practice emanates from the principle that one should not sell assets before they exist, as described by the Ethica Institute of Islamic Finance. The subcategory of mutual funds follows PLS criteria as well as certain others. Second, Islamic finance guidelines exclude consumer goods and services in the following sectors: alcohol, gambling, and certain entertainment and media sectors (for example, pornography). Third, reporting requirements emphasize the transparency and accountability measures that many industrialized countries refer to as corporate governance’s best practices.

Trend #1: Culture of Socially Responsible Investment

The culture of socially responsible investment parallels the fine-tuning of Islamic mutual funds. Similarly, it is only fair to note how the parallel trend of socially responsible investing—which has catalyzed non-Muslim investors’ attraction to Islamic investments—has matured in many regions. Looking back at US investment experiences, SRI is not an entirely new concept; it has simply been reinvigorated. As one working paper stated, it was in “1971 that the first ethical mutual fund, the Pax World Fund, was publicly available to individual investors” to avoid investing in the gambling/casino sector. Both socially conscious and Muslim investors share this concern. As such, the process requires religious scholars to collaborate with fund managers and financial regulators to reconcile the investment process.

Like other social justice causes, SRI focuses on the externalities (e.g. pollution) that many economists describe as the unintended consequences of fully competitive markets and production. In turn, government might intervene with some public finance instruments and tax businesses to address the unintended consequences. However, government regulation creates further problems with bureaucracy and the expectation that oversight checks private forces. For example, because certain sectors, like the alcohol and tobacco industry, are legal, government will impose higher sales tax on these items to curtail consumption and use the tax revenue towards public infrastructure. But socially conscious citizens might not be satisfied with the outcomes and still feel that society must hold certain sectors accountable beyond taxation.

Given these social, economic, and environmental concerns, an SRI fund would appeal to Muslims seeking this type of ethical practice as well. More recently, Muslims outside of Muslim-majority countries have augmented the Islamic finance industry and modernized outlets with respect to the SRI movement. As such, one may argue that a new subcategory of Islamic finance has emerged. In the US, a group of Muslim Americans looking to invest according to Islamic practices approached Nicholas Kaiser, the founder of Saturna Capital, to develop a mutual fund. According to Kaiser, “Muslims in America had a desire to own stocks and they knew there were certain restrictions or guidelines that they should follow. By hiring a mutual fund management company to create a fund to follow those restrictions, they knew it would meet their religious needs to satisfy their goal of buying equities.” Thus in 1986, the Amana Mutual Fund was created, followed by the Amana Growth Fund in 1994. Both are now listed on the Dow Jones Index as AMANX and AMAGX.

Trend #2: Establishing Islamic Markets Indices

In 2008, Dow Jones noted the above and opened up its Middle East office to connect directly with the Islamic finance industry hub in Dubai, where the International Islamic Finance Forum, comprised of policymakers and scholars, is headquartered. They anticipated growing interest in Islamic finance and created the Dow Jones Islamic Market in 1999, thereby beating out the FTSE and Standard & Poor’s (S&P) version of cataloguing Islamic markets by almost a decade. (S&P established one in 2007, followed by FTSE in 2008.)

A debate persists as to how simple or complicated it is for investment managers to implement Islamic finance conditions. For example, critics of Islamic finance argue that complex and sophisticated transactions at an institutional level are still a challenge to Muslim financial scholars. Back in 2009, the Bahrain-based Islamic Banking regulatory body, the Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFI) asserted that 85 percent of Islamic bonds (sukuk) were in fact un-Islamic. Nonetheless, those opting for Islamic investment funds share much in common with others pursuing faith-based investment funds, like the underlying belief in holding both oneself and society accountable for community development. This explains why the larger trend of socially responsible investing will likely grow in popularity as middle-class families grapple with their mistrust of the latest banking crises.

Specifically, the notion of creating wealth for society—and not just the individual—operates as the modern equivalent of SRI’s goals for community investment. As a result, the philosophy of Islamic finance overlaps with socially responsible investment. The only difference is that Islamic finance proposes an entire financial system that interrelates with way of life and specifies rules and principles.

Trend #3: Non-Muslim Majority Countries Take Notice

Other regions with non-Muslim majority populations have taken notice of Islamic finance’s market potential. As a result of a 2004 decision, both Deutsche Bank and Citibank are reaping the benefits of their first mover advantage to open Islamic banking windows, since many European and American banks are holding back from lending. Deutsche Bank projects that the Islamic finance may double in assets of up to 1.8 trillion dollars by 2016. Earlier this year, Islamic Finance News awarded Deutsche Bank “Best Islamic Finance Trustee/Custodian”.

In 2009, other non-Muslim majority countries, like Japan, noticed this trend and started issuing Islamic bonds (sukuk). In addition, mainstream publications like The Atlantic illustrate the business world’s need to engage more directly with Islamic finance practices by offering courses: “Hong Kong University has been one of many institutions for higher learning in the region to establish a degree program in Islamic finance,” writes Massoud Hayoun.

Trend #4: Islamic Banks May Be the Other Side of the SRI Coin

Islamic Banks have grown beyond the GCC and spread to Turkey. Islamic banking enterprises successfully have engaged Turkey’s 70 million—and growing—population and developed American and Middle Eastern ties as Turkey secures its place as a political and regional leader. Banks like Turkiye Finans have developed investment portfolios that address both the Islamic elements as well as the growing need to become more ‘socially responsible’. In 2011, Turkey launched the ISE Participation Index, KATLM. The index is part of an initiative to promote ethical funds and SRIs. (See “Islamic Finance in Turkey–Looking Ahead With Confidence”, 2007, by Peter Wouters.)

About 10 years ago, Turkey experienced frustration over not getting into the European Union. Several reasons were cited, arising both from the Copenhagen Criteria and cultural bias. Ironically, the decision to exclude Turkey has produced hidden blessings: Turkey avoided the Euro financial crisis, and Islamic banking institutions have increased economic and social linkages within a secular country. Meanwhile, Turkey has become as a model country within the MENA region as it increases its investment in Iraq.

Coincidentally, the socially responsible investment trend is growing within cities like Paris and San Francisco, just like it is growing in Hong Kong and Ankara. In the US alone, Sustainable and Responsible Investing is a broad-based approach to investing that now encompasses an estimated $3.07 trillion out of $25.2 trillion in the US investment marketplace today, according to The Forum for Sustainable and Responsible Investing, which parallels the subcategory of faith based funding. Moreover, some industry analysts posit that the larger SRI phenomenon produces gains beyond its ethical benefits. SRI and its subcategories of faith based funds are seen as a market for long-term sustainability because their criteria look at economics, environmental and social issues. SRI is viewed by many industry analysts as the key to sustainability, which is attractive to investors. As such social issues encompass human capital, which function as good indicators of how the company is managing itself: ‘corporate governance’.

Market Potential

The wider market for SRI Funds exist beyond progressive, socially conscious investors—or what investment managers describe as a “niche identity” market representing 2 trillion dollars. Building on this SRI premise, the market potential for Islamic Fund clients is growing. Clients looking towards SRI have money to invest as well as a vested interest. For example, an increasing number of Americans wish to exercise more oversight with their retirement plans, in part because of the Enron and Maddoff scandals. Instead of investing in the typical 401 (k) plans, Americans may invest in 403 (b) plans, which allow more hands on decision-making. As a result, the additional oversight in a 403 (b) plan provides an opportunity to select industries that focus on social and environmental factors. Consequently, there is a large market potential for Islamically managed hedge-funds, given that the Arab Spring countries are considering many types of banking reforms, as stipulated by the Ernst & Young report.

In addition, many non-Muslims are looking for alternative investment options. In the UK and Malaysia, non-Muslims have opted to invest with Islamic finance institutions as a means to observe ethical investment choices. Almost a quarter of Islamic accounts in Malaysia are owned by non-Muslims, according to a BBC report.

Wealthy Muslims in the UK and the US participate in both the Western economy and the Islamic finance sector. Demographicdata by the Pew Forum on Religion & Public Life’s research support this market potential claim as well. Muslims comprise 23.4 percent of the global population, and is expected to increase by 35 percent over the next two decades.

Heightened Awareness

The global financial crises have heightened awareness and increased the investors’ interests in alternative investment strategies. Recognizing the common ground between Islamic finance principles and the modern investor’s vision for more transparency and investing sectors that address social concerns only promotes the most competitive investment strategies. A 2009 Working Paper by Novethic argued that there is no natural link between SRI and Islamic Finance because SRI do “not employ the same expertise or target the same clientele.” Nonetheless, the activity outside of non-Muslim majority countries presents a different story with respect to the global financial crisis and its effects. Overall, as more investors observe the parallel trends, alternatives have widened the scope for both social and financial accountability as well as deepened the hope to avoid a repeat of the unethical financial practices.